**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-QSB**

 

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| ý                                                                                                                                                                                                                                                                                  | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                    |
| **For the quarterly period ended September 30, 2005**                                                                                                                                                                                                                              |
|                                                                                                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                    |
| o                                                                                                                                                                                                                                                                                       | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                    |
| **For  the transition period from                   to                       ** |
|                                                                                                                                                                                                                                                                                    |
| **Commission File Number   0-20191**                                                                                                                                                                                                                                               |

 

**INTRUSIONINC.**

(Exactname of small business issuer as specified in its charter)

 
| **Delaware**                                                     | ** ** | **75-1911917**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**1101 East Arapaho Road, Richardson, Texas 75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Issuer’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days:

Yes ý No o

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act:  Yes o No ý

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on October 28,2005 was 6,909,507.

 

Transitional Small BusinessDisclosure Format (check one):  Yes o No ý

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I –  FINANCIAL INFORMATION**                                                                                    |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                             |   |
| Item 1.  Financial Statements                                                                                               |   |
|                                                                                                                             |   |
| Unaudited  Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31,  2004                       |   |
|                                                                                                                             |   |
| Unaudited  Condensed Consolidated Statements of Operations for the three and nine months  ended September 30, 2005 and 2004 |   |
|                                                                                                                             |   |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the nine months ended September 30,  2005 and 2004           |   |
|                                                                                                                             |   |
| Notes  to Unaudited Condensed Consolidated Financial Statements                                                                  |   |
|                                                                                                                             |   |
| Item 2.   Management’s Discussion and Analysis of Financial Condition and  Results of Operations                       |   |
|                                                                                                                             |   |
| Item 3.   Controls and Procedures                                                                                           |   |
|                                                                                                                             |   |
| **PART II –  OTHER INFORMATION**                                                                                       |   |
|                                                                                                                             |   |
| Item 1.  Legal Proceedings                                                                                                  |   |
|                                                                                                                             |   |
| Item  6.  Exhibits and Reports on Form 8-K                                                                             |   |
|                                                                                                                             |   |
| Signature Page                                                                                                                   |   |

 

2

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**PART I – FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                                                                                                                  | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                  |       |                         |       |                        |       |
| Current Assets:                                                                                                                                                                                             |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                   |       | $                            | 2,398      |                        | $          | 2,315 |   |
| Short-term investments                                                                                                                                                                                      |       | 500                          |       | 75                          |       |
| Accounts receivable, less allowance for  doubtful accounts of $223 in 2005 and $508 in 2004                                                                                                                 |       | 902                          |       | 1,220                       |       |
| Inventories, net                                                                                                                                                                                            |       | 519                          |       | 950                         |       |
| Prepaid expenses                                                                                                                                                                                            |       | 189                          |       | 393                         |       |
| Total  current assets                                                                                                                                                                                       |       | 4,508                        |       | 4,953                       |       |
| Property and equipment, net                                                                                                                                                                                 |       | 294                          |       | 299                         |       |
| Other assets                                                                                                                                                                                                |       | 43                           |       | 64                          |       |
| TOTAL ASSETS                                                                                                                                                                                                |       | $                            | 4,845      |                        | $          | 5,316 |   |
|                                                                                                                                                                                                        |       |                         |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                               |       |                         |       |                        |       |
|                                                                                                                                                                                                        |       |                         |       |                        |       |
| Current Liabilities:                                                                                                                                                                                        |       |                         |       |                        |       |
| Accounts payable and accrued expenses                                                                                                                                                                       |       | $                            | 1,368      |                        | $          | 1,667 |   |
| Deferred revenue                                                                                                                                                                                            |       | 713                          |       | 799                         |       |
| Total current liabilities                                                                                                                                                                                   |       | 2,081                        |       | 2,466                       |       |
| Stockholders’ Equity:                                                                                                                                                                                  |       |                         |       |                        |       |
| Preferred stock – $.01 par value;  authorized shares – 5,000 5% shares issued and outstanding – 389 in 2005 and  840 in 2004; Liquidation preference of $1,994 as of September 30, 2005 |       | 1,375                        |       | 2,968                       |       |
| Series 2 5% shares issued and  outstanding – 500; Liquidation preference of $1,256 as of September 30,  2005                                                                                 |       | 787                          |       | —                      |       |
| Common stock – $.01 par value; authorized  shares – 80,000; Issued shares – 6,714 in 2005 and 5,431 in 2004; Outstanding  shares – 6,704 in 2005 and 5,421in 2004                       |       | 67                           |       | 54                          |       |
| Common stock held in treasury, at cost – 10  shares                                                                                                                                                    |       | (362                         | )          | (362                        | )          |
| Additional paid-in capital                                                                                                                                                                                  |       | 52,251                       |       | 49,095                      |       |
| Accumulated deficit                                                                                                                                                                                         |       | (51,175                      | )          | (48,732                     | )          |
| Accumulated other comprehensive loss                                                                                                                                                                        |       | (179                         | )          | (173                        | )          |
| Total stockholders’ equity                                                                                                                                                                             |       | 2,764                        |       | 2,850                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                             |       | $                            | 4,845      |                        | $          | 5,316 |   |

 

Seeaccompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** |
| Net product revenue                                                        |       | $                      | 1,589      |                   | $          | 1,213 |   | $ | 3,783 |   | $ | 2,762 |   |
| Net customer support and maintenance  revenue                              |       | 389                    |       | 464                    |       | 1,089 |   | 1,285 |   |
| Total revenue                                                              |       | 1,978                  |       | 1,677                  |       | 4,872 |   | 4,047 |   |
| Cost of product revenue                                                    |       | 789                    |       | 726                    |       | 2,010 |   | 1,705 |   |
| Cost of customer support and maintenance  revenue                          |       | 8                      |       | 117                    |       | 54 |   | 351 |   |
| Total cost of revenue                                                      |       | 797                    |       | 843                    |       | 2,064 |   | 2,056 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Gross profit                                                               |       | 1,181                  |       | 834                    |       | 2,808 |   | 1,991 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                                        |       |                   |       |                   |       |   |   |   |   |
| Sales and marketing                                                        |       | 797                    |       | 894                    |       | 2,429 |   | 2,867 |   |
| Research and development                                                   |       | 552                    |       | 613                    |       | 1,957 |   | 1,947 |   |
| General and administrative                                                 |       | 336                    |       | 304                    |       | 868 |   | 884 |   |
| Severance and related costs                                                |       | —                 |       | 5                      |       | 55 |   | 134 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Operating loss                                                             |       | (504                   | )          | (982                   | )          | (2,501 | ) | (3,841 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Other income, net                                                          |       | —                 |       | 26                     |       | 2 |   | 67 |   |
| Interest income, net                                                       |       | 23                     |       | 9                      |       | 56 |   | 34 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Loss before income tax provision                                           |       | (481                   | )          | (947                   | )          | (2,443 | ) | (3,740 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Income tax provision                                                       |       | —                 |       | —                 |       | — |   | — |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Net loss                                                                   |       | $                      | (481       | )                      | $          | (947 | ) | $ | (2,443 | ) | $ | (3,740 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Preferred stock dividends accrued                                          |       | (44                    | )          | (67                    | )          | (129 | ) | (129 | )  |
| Beneficial conversion feature on preferred  stock                          |       | —                 |       | —                 |       | (919 | ) | (938 | ) |
| Net loss attributable to common  stockholders                              |       | $                      | (525       | )                      | $          | (1,014 | ) | $ | (3,491 | ) | $ | (4,807 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Net loss per share attributable to common  stockholders, basic and diluted |       | $                      | (0.08      | )                      | $          | (0.20 | ) | $ | (0.56 | ) | $ | (0.93 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted             |       | 6,586                  |       | 5,166                  |       | 6,270 |   | 5,166 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)

 
| ** **                                                                      | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                      | ** ** | **Sept 30,  2005**    | ** ** | **Sept 30,  2004** | ** ** |
| Operating Activities:                                                           |       |                  |       |   |   |
| Net loss                                                                        |       | $                     | (2,443     | ) | $ | (3,740 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:    |       |                  |       |   |   |
| Depreciation and amortization                                                   |       | 141                   |       | 164 |   |
| Provision for doubtful accounts                                                 |       | (285                  | )          | (108 | ) |
| Changes in operating assets and  liabilities:                                   |       |                  |       |   |   |
| Accounts receivable                                                             |       | 603                   |       | 30 |   |
| Inventories                                                                     |       | 431                   |       | 150 |   |
| Other Assets                                                                    |       | —                |       | 250 |   |
| Prepaid expenses and other assets                                               |       | 227                   |       |   |   |
| Accounts payable and accrued expenses                                           |       | (291                  | )          | (561 | ) |
| Deferred revenue                                                                |       | (86                   | )          | 107 |   |
| Net cash used in operating activities                                           |       | (1,703                | )          | (3,708 | ) |
| Investing Activities:                                                           |       |                  |       |   |   |
| Purchases of short-term investments                                             |       | (2,350                | )          | (3,100 | ) |
| Maturities of short-term investments                                            |       | 1,925                 |       | 3,035 |   |
| Purchases of property and equipment                                             |       | (136                  | )          | (126 | ) |
| Net cash used in investing activities                                           |       | (561                  | )          | (191 | ) |
| Financing Activities:                                                           |       |                  |       |   |   |
| Proceeds from the exercise of employee  stock options                           |       | —                |       | 6 |   |
| Dividends paid on preferred stock                                               |       | (137                  | )          | — |   |
| Proceeds from the issuance of preferred  stock and warrants, net                |       | 2,490                 |       | 4,725 |   |
| Net cash provided by financing activities                                       |       | 2,353                 |       | 4,731 |   |
|                                                                            |       |                  |       |   |   |
| Effect of foreign currency translation  adjustment on cash and cash equivalents |       | (6                    | )          | — |   |
|                                                                            |       |                  |       |   |   |
| Net increase in cash and cash equivalents                                       |       | 83                    |       | 832 |   |
| Cash and cash equivalents at beginning of  period                               |       | 2,315                 |       | 974 |   |
| Cash and cash equivalents at end of period                                      |       | $                     | 2,398      |   | $ | 1,806 |   |
|                                                                            |       |                  |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                      |       |                  |       |   |   |
|                                                                            |       |                  |       |   |   |
| Fair value of warrants issued in connection  with sale of preferred stock       |       | $                     | 815        |   | $ | 1,191 |   |
| Amortization of preferred stock beneficial  conversion feature                  |       | $                     | 919        |   | $ | 938 |   |
| Preferred stock dividends accrued                                               |       | $                     | 129        |   | $ | 129 |   |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.               Description of Business

 

Wedevelop, market and support a family of regulated information compliance anddata privacy protection products, entity identification systems along withnetwork intrusion prevention and detection systems that address vital securityissues facing organizations with mission critical business applications orhousing classified, confidential, or customer information assets.  Ourproducts include Compliance CommanderTM for regulated information and dataprivacy protection, TraceCopTM for entity identification and location, SpySnareTMfor real-time inline blocking of spyware and unwanted peer-to-peerapplications, and SecureNetTM for network intrusion prevention and detection.

 

We market and distribute ourproducts through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers.  Ourend-user customers include high technology, manufacturing, telecommunications,retail, transportation, health care, insurance, entertainment, utilities andenergy companies, government entities, financial institutions, and academicinstitutions.

 

We were organized in Texasin September 1983 and reincorporated in Delaware in October 1995.  For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks.  On June 1, 2000, wechanged our name from ODS Networks, Inc. to Intrusion.com, Inc., andour Nasdaq ticker symbol from ODSI to INTZ to reflect our focus on intrusiondetection solutions.  On November 1,2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. Information contained in or linked to our website are not a part of thisreport.  References to “we,” “us” and “our”in this report refer to Intrusion Inc. and its subsidiaries.

 

As of September 30,2005, we had cash, cash equivalents and short-term investments in the amount ofapproximately $2.9 million, up from approximately $2.4 million as of December 31,2004.  This cash increase is primarilythe result of the sale of our Series 2 5% preferred stock discussed inNote 7.  Although we believe we havesufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, based on our internal estimates andour operating plan, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  Moreover, despiteactions to reduce our costs and improve our profitability, our operating lossesand net operating cash outflows may continue through at least the fourthquarter of 2005.  As a result, we may notbe able to achieve the revenue and gross margin objectives necessary to achievepositive cash flow or profitability without obtaining additional equityfinancing.  In addition, we believe wemay need to seek additional equity financing in order to remain in compliancewith Nasdaq’s continued listing requirement of at least $2.5 million ofstockholders’ equity.  We do notcurrently have any arrangements for financing and we may not be able to secureadditional debt or equity financing on terms acceptable to us, or at all, atthe time when we need such funding.  Ifour business does not generate sufficient cash flow from operations andsufficient future financings are not available, we may not be able to operateor grow our business, pay our expenses when due, fund our other liquidity needsor maintain our listing on The Nasdaq SmallCap Market.  Moreover, any financing raised by us mayrestrict our business activities or future capital raising efforts or causedilution to our current stockholders.

 

2.               Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-QSB and Item310 of Regulation S-B.  Accordingly, theydo not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2004balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States.  However,we believe that the disclosures are adequate to make the information presentednot misleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three and nine month periods ending September 30,2005 are not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in the Company’s annual report on Form 10-KSBfor the year ended December 31, 2004.

 

6

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3.               Inventories (In thousands)

 
| ** **              | ** ** | **Sept 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------|------------|--------------------|------------|-----------------------------|------------|
|                    |       |               |       |                        |       |
| Inventories consist of: |       |               |       |                        |       |
|                    |       |               |       |                        |       |
| Finished goods          |       | $                  | 378        |                        | $          | 743 |   |
| Work in progress        |       | 93                 |       | 18                          |       |
| Demonstration systems   |       | 48                 |       | 189                         |       |
| Net inventory           |       | $                  | 519        |                        | $          | 950 |   |

 

4.               Accounting for Stock-Based Compensation

 

We account for employeestock-based compensation in accordance with APB 25.  The following table summarizes relevantinformation as to the reported results under our intrinsic value method ofaccounting for stock awards, with supplemental information as if the fair valuerecognition provision of SFAS 123 as amended by SFAS 148 had been applied thequarters and nine months ended September 30, 2005 and September 30,2004 (in thousands, except per share data).

 
| ** **                                                                                             | ** ** | **Quarter  Ended  Sept 30,  2005** | ** ** | **Quarter  Ended  Sept 30,  2004** | ** ** | **Nine  Months  Sept 30,  2005** | ** ** | **Nine  Months  Sept 30,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
|                                                                                                   |       |                                    |       |                                    |       |                                  |       |                                  |       |
| Net loss attributable to common  stockholders                                                          |       | $                                       | (525       | )                                       | $          | (1,014                                | )          | $                                     | (3,491     | ) | $ | (4,807 | ) |
| Deduct:   Total stock-based compensation determined under fair value-based  method for all awards |       | (283                                    | )          | (44                                     | )          | (589                                  | )          | (164)                                 |       |
| Pro forma net loss attributable to common  stockholders                                                |       | $                                       | (808       | )                                       | $          | (1,058                                | )          | $                                     | (4,080     | ) | $ | (4,971 | ) |
| Net loss per share attributable to common  stockholders:                                               |       |                                    |       |                                    |       |                                  |       |                                  |       |
| as reported (basic and diluted)                                                                        |       | $                                       | (0.08      | )                                       | $          | (0.20                                 | )          | $                                     | (0.56      | ) | $ | (0.93 | ) |
| pro forma (basic and diluted)                                                                          |       | $                                       | (0.12      | )                                       | $          | (0.20                                 | )          | $                                     | (0.65      | ) | $ | (0.96 | ) |
| Weighted-average shares used in  computation:                                                          |       |                                    |       |                                    |       |                                  |       |                                  |       |
| Basic and diluted                                                                                      |       | 6,586                                   |       | 5,166                                   |       | 6,270                                 |       | 5,166                                 |       |
|                                                                                                        |            |                                         |            |                                         |            |                                       |            |                                       |            |  |  |  |  |  |  |  |

 

As required, the pro formadisclosures above include options granted since January 1, 1995.  Consequently, the effects of applying SFAS123 and SFAS 148 for providing pro forma disclosures may not be representativeof the effects on reported operating results for future years until all optionsoutstanding are included in the pro forma disclosures.  For purposes of pro forma disclosures, theestimated fair value of stock-based compensation plans and other options areamortized to expense primarily over the vesting period.

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), which replaces SFAS 123 and supersedes APB Opinion No. 25.SFAS 123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the financial statements based ontheir fair values. The pro forma disclosures previously permitted under SFAS123 no longer will be an alternative to financial statement recognition. Forthe Company, SFAS 123R is effective for periods beginning after December 15,2005. Early application of SFAS 123R is encouraged, but not required. We planto adopt SFAS 123R on January 1, 2006 using the modified prospectiveapplication method described in the statement. Under the modified prospectiveapplication method, we will apply the standard to new awards and to awardsmodified, repurchased, or cancelled after the required effective date.Additionally, compensation cost for the unvested portion of awards outstandingas of the required effective date will be recognized as compensation expense asthe requisite service is rendered after the required effective date.

 

We are evaluating the impact of adopting SFAS 123R and expect that wewill record substantial non-cash stock compensation expenses. The adoption ofSFAS 123R is not expected to have a significant effect on our financialcondition or cash flows but is expected to have a significant, adverse effecton our results of operations.  The futureimpact of the adoption of SFAS 123R cannot be predicted at this time because itwill depend on levels of share-based payments granted by us in the future.  However, had we adopted SFAS 123R in priorperiods, the impact of that standard would have approximated the impact of SFAS123 as described in the disclosure of pro forma net loss attributable to commonstockholders included above.

 

7

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5.               Net Loss Per Share

 

Basic net loss per share iscomputed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders by theweighted average number of common shares and common stock equivalentsoutstanding for the period.  Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the loss per share calculation for the periods ended September 30,2005 and 2004 are 3,247,451 and 2,607,197, respectively.  Our common stock equivalents are not includedin the diluted loss per share for the three and nine-month periods ended September 30,2005 and 2004, as they are antidilutive.

 

6.               Commitments and Contingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact**.**

 

7.               Preferred Stock

 

On March 28, 2005, we completed a $2.7 million private placementof Series 2 5% preferred stock and warrants.  In the private placement, we sold 1,065,200shares of preferred stock at a price of $2.50 per share for gross proceeds of$2.7 million, less $173,000 of issuance costs. The shares of Series 2 5% preferred stock are convertible into1,065,200 shares of common stock at an initial conversion price of $2.50 pershare.  Holders of the Series 2 5%preferred stock include 160,000 shares purchased by our CEO and 60,000 sharespurchased by a director of the Company.

 

The 5% dividends accruing on the Series 2 5% preferred stock arerequired to be paid quarterly on the first business day in March, June, September andDecember of each year, beginning with June 2005.  The liquidation preference for the preferredstock is an amount equal to $2.50 per share plus any accrued and unpaiddividends.  Holders of our Series 2 5%preferred stock have liquidation preference rights over our 5% preferred stockholders as well as our common stock holders. The holders of the Series 2 5% preferred stock are not entitled tovote on any matter, except as otherwise required by law or with respect tocertain limited matters specified in the Certificate of Designations creatingthe Series 2 5% preferred stock.

 

Included in this transaction were warrants to purchase 532,600 sharesof common stock at an exercise price of $2.77 per share.  Warrant holders include 80,000 held by ourCEO and 30,000 held by a director of the Company.  The relative fair value of these warrants wasvalued at $0.7 million using the Black-Scholes model and has been recorded as adiscount to the Series 2 5% preferred stock and an increase in additionalpaid-in capital.  The issuance of thesewarrants also resulted in a beneficial conversion feature to the Series 25% preferred stock valued at $0.9 million. In accordance with EITF 98-5, the beneficial conversion feature wasfully amortized in the first quarter of 2005, as the preferred stock does nothave a stated maturity and is immediately convertible into common stock.  This beneficial conversion feature isincluded in the net loss attributed to common stockholders.  In connection with the closing of thisprivate placement, we issued warrants to purchase 60,390 shares of our commonstock at an exercise price of $2.77 per share to two affiliates of ourfinancial advisor for assistance with the private placement.  These warrants were valued at $0.1 millionusing the Black-Scholes model and have been recorded as a discount to the Series 25% preferred stock and an increase to additional paid-in capital.

 

The Series 2 5% preferred stock was recorded as the net of theproceeds of $2.7 million less $173,000 issuance costs and the fair value of thewarrants issued in conjunction with the Series 2 5% preferred stocktotaling $0.8 million.

 

Holders of Series 25% preferred stock have the right to require us to redeem any or all of thetheir shares upon the occurrence of certain events within the Company’s controlthat are defined in Certificate of Designation at a price equal the sum of (1) thegreater of $3.25****and the productof the volume weighted average price of our common stock on the trading dayimmediately preceding the event multiplied by $2.50 divided by the conversionprice then in effect plus (2) any accrued but unpaid dividends on the Series 25% preferred stock plus (3) all liquidated damages or other amountspayable to the holders of Series 2 5% preferred stock.

 

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8.               Common Stock

 

During the three monthsended September 30, 2005, 220,000 shares of our Series 2 5% preferredstock were converted into 220,000 shares of common stock.  In addition, an employee exercised stockoptions to purchase 501 shares of common stock.

 

During the nine monthsended September 30, 2005, 450,912 shares of our 5% preferred stock wereconverted into 717,099 shares of common stock and 565,200 shares of Series 25% preferred stock were converted into 565,200 shares of common stock.  In addition, an employee exercised stockoptions to purchase 668 shares of common stock.

 

9.               Comprehensive Loss

 

SFAS No. 130,Reporting Comprehensive Income, establishes standards for the reporting anddisplay of comprehensive loss and its components.  SFAS No. 130 requires, among otherthings, that foreign currency translation adjustments be included in othercomprehensive loss.  The followingstatement presents comprehensive loss for the three and nine months ended September 30,2005 and 2004 (in thousands):

 
| ** **                                    | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                    | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
| ** **                                    | ** ** | **2005**                | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss attributable to common  shareholders |       | $                       | (525       | )                      | $          | (1,014 | ) | $ | (3,491 | ) | $ | (4,807 | ) |
| Other comprehensive income (loss):            |       |                    |       |                   |       |   |   |   |   |
| Foreign currency translation adjustment       |       | —                  |       | —                 |       | 6 |   | — |   |
| Comprehensive loss                            |       | $                       | (525       | )                      | $          | (1,014 | ) | $ | (3,485 | ) | $ | (4,807 | ) |

 

Item 2.                                MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, market acceptance of our products, theimpact of sustained losses on our ability to successfully operate and grow ourbusiness, our stock price and our ongoing Nasdaq eligibility, the highlycompetitive market for our products, the effects of sales and implementationcycles for our new products on our quarterly results, difficulties inaccurately estimating market growth, the consolidation of the informationsecurity industry, the impact of changing economic conditions, businessconditions in the information security industry, our ability to manageacquisitions effectively, our ability to manage discontinued operationseffectively, the impact of market peers and their products as well as risksconcerning future technology and others identified in our Annual Report on Form 10-KSBand other Securities and Exchange Commission filings.  Such forward-looking statements are generallyaccompanied by words such as “plan,” “estimate,” “expect,” “believe,” “should,”“would,” “could,” “anticipate,” “may” or other words that convey uncertainty offuture events or outcomes.  Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of1995.  The section below entitled “FactorsThat May Affect Future Results of Operations” sets forth and incorporatesby reference certain factors that could cause actual future results of the Companyto differ materially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourunaudited condensed consolidated financial statements, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

 

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*RevenueRecognition*

 

We generally recognizeproduct revenue upon shipment of product. We accrue for estimated warrantycosts and sales returns at the time of shipment based on our experience.Revenue from maintenance contracts is deferred and recognized over thecontractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, our warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  If our warranty costs exceed ourexpectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriate reservepercentage.  However, to date, warrantycosts and sales returns have not been material. Historically, our estimates for these items have not differed materiallyfrom actual results.  We believe that ourrevenue recognition policy does not include significant or subjectiveestimates.

 

We recognize softwarerevenue from the licensing of our software products in accordance withStatement of Position (“SOP”) No. 97-2 “Software Revenue Recognition”, SOP98-9 “Modification of 97-2, Software Revenue Recognition, with respect tocertain transactions” and Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition” whereby revenue from the licensing of our products is notrecognized until all four of the following have been met: (1) execution ofa written agreement; (2) delivery of the product has occurred; (3) thefee is fixed and determinable; and (4) collectibility is probable. Bundledhardware and perpetual software product sales are recognized at time ofdelivery, as our licenses are not sold on a subscription basis.  In the case of multiple product and servicesales, we perform a Vendor Specific Objective Evidence analysis toappropriately determine the amount of revenue derived from eachdeliverable.  If our license strategychanges and we begin to offer licenses on a subscription basis, we wouldperform this analysis in a similar manner. Under these circumstances, the revenue related to the license would berecognized ratably over the subscription period.  Market values are easily obtained for all ofour product offerings, as we have historical sales information on our productofferings.  We defer and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

 

We have signed distributionagreements with distributors in the United States, Europe and Asia. In general,these relationships are non-exclusive. Distributors typically maintain aninventory of our products. Under these agreements, we provide certainprotection to the distributors for their inventory of our products for pricereductions as well as products that are slow moving or have been discontinuedby us.  Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor. Revenue, offset by deferred cost of sales, is included indeferred revenue in the accompanying financial statements.  Since the net balance in deferred revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in ourobsolescence and slow-moving analysis and are written down according to theircurrent value.  This transaction,effectively recognizes expense for the write-down, if any, and increases thenet liability in the deferred revenue account.

 

We generally recognizeservice revenue upon delivery of the contracted service.  Service revenue, primarily includingmaintenance, training and installation are recognized upon delivery of theservice and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowancefor Doubtful Accounts and Returns*

 

Trade accounts receivableare stated at the amount we expect to collect. We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments.  Management considers the following factorswhen determining the collectibility of specific customer accounts:  customer credit-worthiness, past transactionhistory with the customer, current economic industry trends, and changes incustomer payment terms.  Our receivablesare uncollateralized and we expect to continue this policy in the future.  If the financial condition of our customerswere to deteriorate, adversely affecting their ability to make payments,additional allowances would be required. Based on management’s assessment, we provide for estimated uncollectibleamounts through a charge to earnings and a credit to a valuationallowance.  Balances that remainoutstanding after we have used reasonable collection efforts are written offthrough a charge to the valuation allowance and a credit to accountsreceivable.  Historically, our estimatesfor sales returns and doubtful accounts have not materially differed fromactual results.

 

*Inventory*

 

We write down our inventoryfor estimated obsolescence or unmarketable inventory equal to the differencebetween the cost of inventory and the estimated market value based uponassumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. Historically, our estimates for inventory obsolescence have not differedmaterially from actual results.

 

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Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** |
| Net product revenue                               |       | 80.3                   | %          | 72.3                   | %          | 77.6 | % | 68.2 | % |
| Net customer support and maintenance  revenue     |       | 19.7                   |       | 27.7                   |       | 22.4 |   | 31.8 |   |
| Total revenue                                     |       | 100.0                  |       | 100.0                  |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                           |       | 39.9                   |       | 43.3                   |       | 41.3 |   | 42.1 |   |
| Cost of customer support and maintenance  revenue |       | 0.4                    |       | 7.0                    |       | 1.1 |   | 8.7 |   |
| Total cost of revenue                             |       | 40.3                   |       | 50.3                   |       | 42.4 |   | 50.8 |   |
| Gross profit                                      |       | 59.7                   |       | 49.7                   |       | 57.6 |   | 49.2 |   |
| Operating expenses:                               |       |                   |       |                   |       |   |   |   |   |
| Sales and marketing                               |       | 40.3                   |       | 53.3                   |       | 50.0 |   | 70.9 |   |
| Research and development                          |       | 27.9                   |       | 36.6                   |       | 40.2 |   | 48.1 |   |
| General and administrative                        |       | 17.0                   |       | 18.1                   |       | 17.8 |   | 21.8 |   |
| Severance and related costs                       |       | —                 |       | 0.3                    |       | 1.1 |   | 3.3 |   |
| Operating loss                                    |       | (25.5                  | )          | (58.6                  | )          | (51.3 | ) | (94.9 | ) |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Other income, net                                 |       | —                 |       | 1.6                    |       | 0.0 |   | 1.7 |   |
| Interest income, net                              |       | 1.2                    |       | 0.5                    |       | 1.1 |   | 0.8 |   |
| Loss before income tax provision                  |       | (24.3                  | )          | (56.5                  | )          | (50.2 | ) | (92.4 | ) |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Income tax provision                              |       | —                 |       | —                 |       | — |   | — |   |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Net loss                                          |       | (24.3                  | )%         | (56.5                  | )%         | (50.2 | )% | (92.4 | )% |
| Preferred stock dividends accrued                 |       | (2.2                   | )          | (4.0                   | )     | (2.6 | ) | (3.2 | )  |
| Beneficial conversion feature on preferred  stock |       | —                 |       | —                 |       | (18.9 | ) | (23.2 | )  |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Net loss attributable to common  stockholders     |       | (26.5                  | )%         | (60.5                  | )%         | (71.7 | )% | (118.8 | )% |

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------|------------|------------------------|------------|------------------------|------------|
| ** **          | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** |
| Domestic revenues   |       | 91.0                   | %          | 84.5                   | %          | 89.4 | % | 78.2 | % |
| Export revenues to: |       |                   |       |                   |       |   |   |   |   |
| Europe              |       | 7.3                    |       | 8.8                    |       | 7.5 |   | 13.3 |   |
| Canada              |       | 0.2                    |       | 2.1                    |       | 0.5 |   | 4.1 |   |
| Asia                |       | 1.4                    |       | 4.4                    |       | 2.5 |   | 4.1 |   |
| Latin America       |       | 0.1                    |       | 0.2                    |       | 0.1 |   | 0.3 |   |
|                |       |                   |       |                   |       |   |   |   |   |
| Net revenues        |       | 100.0                  | %          | 100.0                  | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Net revenues for the quarter and ninemonths ended September 30, 2005 were $2.0 million and $4.9 million, respectively,compared to $1.7 million and $4.0 million for the same periods in 2004.  Product revenues increased $0.4 million and$1.0 million for the quarter and nine months ended September 30, 2005compared to the same periods in 2004. Customer support and maintenance revenue decreased $0.1 million and $0.2million for the quarter and nine months ended September 30, 2005 comparedto the same periods in 2004.  Consistentwith our strategic move to concentrate on our Intrusion Prevention/Detection,Entity Identification and Regulated Information Compliance and Data Privacyproducts, total revenues (including maintenance and support) for the quarterand nine months ended September 30, 2005 from this product line increasedto $1.9 million and $4.6 million from $1.4 million and $3.6 million for thesame periods in 2004.  Our first generation product sales, includingPDS and SecureCom decreased for the quarter and nine months ended September 30,2005 to $0.1 million and $0.2 million from $0.3 million and $0.4 million fromthe same periods in 2004.

 

**ExportRevenues**.  Export revenues for the quarter andnine months ended September 30, 2005 decreased to $0.2 million and $0.5 millionfrom $0.3 million and $0.9 million compared to the same periods in 2004 asrevenues from our PDS security appliance family decreased and we focused moreof our resources domestically.

 

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**Concentrationof Revenues**.  Revenues from sales to various U.S.government entities totaled $1.5 million, or 77.0% of revenues, for the quarterended September 30, 2005 compared to $0.9 million, or 56.4% of revenues,for the same period in 2004.  Revenuesfrom sales to various U.S. government entities totaled $3.6 million, or 73.4%of revenues, for the nine months ended September 30, 2005 compared to $1.9million, or 45.9% of revenues, for the same period in 2004.  Although, we expect our concentration ofrevenues to vary among customers in future quarters depending upon the timingof certain sales, we anticipate that sales to government customers willcontinue to account for a significant portion of our revenues in futurequarters.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including potential disruption toappropriation and spending patterns and the government’s reservation of theright to cancel contracts and purchase orders for its convenience.  Although we do not believe that thecancellation of any particular order would have a material adverse effect onour financial results or that any of our revenues with government customers aresubject to renegotiation, a large number of cancelled or renegotiatedgovernment orders could have a material adverse effect on our financialresults.  Currently, we are not aware ofany proposed cancellation or renegotiation of any of our existing arrangementwith government entities and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

 

**GrossProfit**.  Gross profit was $1.2 million or 59.7%of net revenues for the quarter ended September 30, 2005, compared to $0.8million or 49.7% of net revenues for the quarter ended September 30, 2004.Gross profit was $2.8 million or 57.6% of net revenues for the nine monthsended September 30, 2005, compared to $2.0 million or 49.2% of netrevenues for the nine months ended September 30, 2004. Gross profitmargins as a percentage of net revenues increased from the same period in theprior year due to a continued shift in product mix, to our more profitablesoftware-based products.  Gross profit onproduct revenues for the quarter and nine months ended September 30,increased from 40.1% and 38.3%, respectively, in 2004 to 50.3% and 46.9%,respectively, in 2005 due to the transition to our more profitablesoftware-based products.  Gross profit oncustomer support and maintenance revenues for the quarter and nine months endedSeptember 30, increased from 74.8% and 72.7%, respectively, in 2004 to97.9% and 95.0%, respectively, in 2005, as less repair costs associated withmaintenance contracts were incurred during the quarter and nine months during2005 in conjunction with our transition to software-based products.

 

Gross profit as a percentageof net revenues is impacted by several factors, including shifts in productmix, changes in channels of distribution, revenue volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Sales andMarketing**.  Sales and marketing expenses decreasedto $0.8 million for the quarter ended September 30, 2005, compared to $0.9million for the quarter ended September 30, 2004. Sales and marketingexpenses decreased to $2.4 million for the nine months ended September 30,2005, compared to $2.9 million for the nine months ended September 30,2004. This cost reduction was primarily due to the reorganization of our salesand marketing departments, including a reduction in headcount, and other costreduction initiatives.  Sales andmarketing expenses may vary in the future. However, we believe that these costs will remain relatively constant throughthe end of 2005.

 

**Researchand Development**.  Research and development expensesremained constant at $0.6 million for the quarters ended September 30,2005 and 2004. Research and development expenses increased to $2.0 million forthe nine months ended September 30, 2005, compared to $1.9 million for thenine months ended September 30, 2004. Research and development costs areexpensed in the period incurred. Research and development expenses increased slightly in the nine monthsended September 30, 2005, compared to the same periods in 2004 as weincurred slightly more material-related development costs during the period.Research and development expenses may vary in the future; however, we believethat these costs will remain relatively constant through the end of 2005.

 

**General andAdministrative**.  General and administrative expensesremained constant at $0.3 million for the quarters ended September 30,2005 and 2004.  General andadministrative expenses remained constant at $0.9 million for the nine monthsended September 30, 2005 and 2004. It is expected that general and administrative expenses will remainrelatively constant throughout the remainder of 2005, as no further headcountreductions are anticipated.  General andadministrative expense may vary in the future.

 

**Severanceand Related Costs. **We did not incurseverance and related costs during the quarter ended September 30, 2005compared to $5 thousand for the same period in 2004.  Severance costs decreased to $55thousand for the nine-month period ended September 30, 2005, compared to$134 thousand for the nine-month period ended September 30, 2004.  Severance and related costs during thenine-month period ended September 30, 2005 consisted primarily of paymentsmade during the periods as a result of prior reductions in force.  Severance and related costs for the nine-monthperiod ended September 30, 2004 consisted of reductions in force madeduring those periods.

 

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**Interest**.  Netinterest income increased to $23 thousand for the quarter ended September 30,2005 compared to $9 thousand for the same period in 2004.  Net interest income increased to $56 thousandfor the nine months ended September 30, 2005 compared to $34 thousand forthe same period in 2004.  The increase ininterest income was primarily due to better returns over prior year andrelatively constant cash and short-term investment balances when compared toprior year.  Net interest income may varyin the future based on our cash flow and rate of return on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at September 30, 2005 is approximately $2.4 million of cash andcash equivalents and $0.5 million of short-term investments.  At September 30, 2005 working capitalwas $2.4 million compared to $3.3 million at September 30, 2004.

 

Cash used inoperations for the nine months ended September 30, 2005 was $1.7 million,primarily due to a net loss of $2.4 million, a decrease in accounts payable andaccrued expenses of $0.3 million, a reduction in the provision for doubtfulaccounts of $0.3 million and a reduction in deferred revenue of $0.1million.  This cash decrease waspartially offset by depreciation expense of $0.1 million, a decrease inaccounts receivable of $0.6 million, a decrease in inventories of $0.4 millionand a decrease in prepaid expenses and other assets of $0.2 million.  Cash used in operations for the ninemonths ended September 30, 2004 was $3.7 million, primarily due to anoperating loss of $3.7 million, a decrease in accounts payable and accruedexpenses of $0.6 million and a decrease in the provision for doubtful accountsof $0.1 million.  This cash usage waspartially offset by depreciation and amortization of $0.2 million, a decreasein inventories of $0.2 million, an increase in deferred revenue of $0.1 millionand a decrease in other assets of $0.3 million. Future fluctuations in inventory balances, accounts receivableand accounts payable will be dependent upon several factors, including, but notlimited to, quarterly sales, our strategy in building inventory in advance ofreceiving orders from customers, and the accuracy of our forecasts of productdemand and component requirements.

 

Cash used in investingactivities in the nine months ended September 30, 2005 was $0.6 million,which consisted primarily of the purchase of short-term investments of $2.4million and net purchases of property and equipment of $0.1 million, which wasoffset partially by maturities of short-term investments of $1.9 million,compared to cash used in investing activities in the nine months ended September 30,2004 of $0.2 million, which consisted primarily of the net purchase ofshort-term investments of $0.1 million and net purchases of property andequipment of $0.1 million.

 

Cash provided by financingactivities in the nine months ended September 30, 2005 was $2.4 million,consisting of net financing proceeds from a private placement of $2.5 million,partially offset by payment of dividends on preferred stock of $137 thousand,compared to cash provided by financing activities in the nine months ended September 30,2004 was $4.7 million, consisting of net financing proceeds from a privateplacement of $4.7 million and the exercise of employee stock options of $6thousand.

 

At September 30,2005, the Company did not have any material commitments for capitalexpenditures.

 

During the nine monthsended September 30, 2005, the Company funded its operations throughfinancing proceeds raised during the first quarter of 2005 as well as the useof cash, cash equivalents and sales of short-term investments.

 

Based on our financialprojections, we expect that our cash on hand, along with our short-terminvestments, and cash from our operations will be sufficient to fund ouroperations for the next 12 months. However, our projections are dependent upon our ability to meet ourrevenue and gross profit targets.  Wefunded our operations and met our cash requirements during the nine monthsended September 30, 2005 through financing proceeds on preferred stock andthe use of cash, cash equivalents and sales of short-term investments.  Although we believe we have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  Moreover, despite actions to reduce our costsand improve our profitability, our operating losses and net operating cashoutflows may continue through at least the fourth quarter of 2005.  As a result, we may not be able toachieve the revenue and gross margin objectives necessary to achieve positivecash flow or profitability withoutobtaining additional equity financing. In addition, we believe we may need to seek additional equity financingin order to remain in compliance with Nasdaq’s continued listingrequirement of at least $2.5 million of stockholders’ equity.  We do not currently have any arrangements forfinancing, and we may not be able to secure additional debt or equity financingon terms acceptable to us, or at all, at the time when we need suchfunding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due, fund our other liquidity needs or maintain our listing onThe Nasdaq SmallCap Market.  Moreover, any financing raised by us mayrestrict our business activities or future capital raising efforts or causedilution to our current stockholders.

 

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We may explore the possibleacquisitions of businesses, products and technologies that are complementary toour existing business.  We are continuingto identify and prioritize additional security technologies, which we may wishto develop, either internally or through the licensing, or acquisition ofproducts from third parties.  While wemay engage from time to time in discussions with respect to potentialacquisitions, there can be no assurances that any such acquisitions will bemade or that we will be able to successfully integrate any acquiredbusiness.  In order to finance suchacquisitions and working capital it may be necessary for us to raise additionalfunds through public or private financings. Any equity or debt financings, if available at all, may be on terms,which are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders.

 

Off-Balance SheetArrangements.

 

As of September 30,2005, we did not have any significant off-balance sheet arrangements, asdefined by Item 303(c)(2) of Regulation S-B.

 

Factors That May AffectFuture Results of Operations 

 

Numerous factors may affectour business and future results of operations. These factors include current economic and market conditions, the effectof military actions on government and corporate spending on informationsecurity products, spending patterns of, and appropriations to, U.S. governmentdepartments, technological changes, competition and market acceptance,acquisitions, product transitions, timing of orders, manufacturing andsuppliers, reliance on outsourcing vendors and other partners, intellectualproperty and licenses, third-party products, dependence on governmentcustomers, international operations, intellectual property issues, liquidityand cash resources and effects of restructuring plans and cost reductions.  The discussion below addresses some of theseand other factors.  For a more thoroughdiscussion of these and other factors that may affect our business and futureresults, see the discussion under the caption “Factors That May AffectFuture Results of Operations” in our Annual Report on Form 10-KSB for the yearended December 31, 2004.

 

***Our cash, cash equivalents, and investments have increasedapproximately $0.5 million in the last nine months but have generally declinedsince 2003.  As a result of our expectedcontinuing net cash outflows, we may not have sufficient cash to operate ourbusiness, and we may need to raise additional equity financing to maintain ourNasdaq listing.***

 

During the nine months endedSeptember 30, 2005, our cash, cash equivalents and short-term investmentsincreased approximately $0.5 million from approximately $2.4 million as of December 31,2004 to approximately $2.9 million at September 30, 2005, primarily as aresult of a private placement of our preferred stock and warrants, that yieldednet proceeds of $2.5 million, which we completed on March 28, 2005.  As of December 31, 2004, we had cash,cash equivalents and short-term investments in the amount of approximately $2.4million, down from approximately $2.7 million as of December 31,2003.  Although we believe the proceedswe received in connection with the private placement in March 2005 willprovide us with sufficient cash resources to finance our operations for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control. Moreover,despite our actions to reduce costs and improve profitability, our netoperating losses and net operating cash outflows may continue through at leastthe fourth quarter of 2005.  As a result,we believe our stockholders’ equity could fall below $2.5 million.  If this occurs, we would not be in compliancewith the Nasdaq listing requirements, and we would need to raise additionalequity financing to avoid delisting. Although we may need to secure this financing to maintain our listing onNasdaq, we do not currently have any arrangements for equity financing.  Furthermore, we may not be able to secureadditional debt or equity financing on terms that are acceptable to us, or atall, on a timely basis.  Therefore, ifour business does not generate sufficient cash flow from operations andsufficient financing resources are not available, we may not be able to operateor grow our business, pay our expenses when due, fund our other liquidity needsor maintain our listing on The Nasdaq SmallCap Market.

 

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***If we fail to respond to rapid technological changes in the networksecurity, data protection, regulated information compliance and spywareprevention industries, we may lose customers or our products may becomeobsolete.***

 

The network security, dataprotection, regulated information compliance and spyware prevention industriesare characterized by frequent product introductions, rapidly changingtechnology and continued evolution of industry standards.  We must introduce upgrades to our productsrapidly in response to customer needs, such as new computer viruses or othernovel external attacks on computer networks as well as the adoption privacy anddata protection laws.  In addition, thenature of the network security, data protection, regulated informationcompliance and spyware prevention industries requires our products to becompatible and interoperable with numerous security products, networkingproducts, workstation and personal computer architectures and computer andnetwork operating systems offered by various vendors, including ourcompetitors.  As a result, our successdepends upon our ability to develop and introduce in a timely manner newproducts and enhancements to our products that meet changing customerrequirements and evolving industry and legal standards. The development oftechnologically advanced network security, data protection, regulatedinformation compliance and spyware prevention products is a complex anduncertain process requiring high levels of innovation, rapid response andaccurate anticipation of technological and market trends.  We cannot assure you that we will be able toidentify, develop, manufacture, market or support new or enhancedproducts successfully in a timely manner. Further, the introduction of new products or product enhancements by usor our competitors or the adoption of new or amended privacy or data protectionlaws may shorten the life cycle of our existing products or cause our existingproducts to become obsolete.

 

***Although our revenues have increased to $4.9 million for the first ninemonths of 2005 from $4.0 for the same period in 2004, our overall revenues havedeclined from $7.8 million in 2002 to $6.0 million in 2004 in connection with ashift to sales of our newer product lines. If our network intrusion detection,regulated information compliance system, data privacy system and spyware preventionproducts do not achieve market acceptance, our revenues will suffer.***

 

Over the past three years,we have transitioned our sales strategy from our lower margin SecureCom and PDSsecurity appliance products to the development and sales of our higher marginnetwork intrusion detection, regulated information compliance system, dataprivacy protection and spyware prevention products.  During this transition, sales of our newproducts were not enough to counteract the loss in sales associated with ourolder products.  As a result, althoughour revenues for the nine months ended September 30, 2005 increased to$4.9 million from $4.0 million for the same period in 2004, our overall netrevenues have declined from approximately $7.8 million in 2002, to approximately$6.5 million in 2003 and approximately $6.0 million in 2004.

 

Our new network securityproducts, regulated information compliance systems, data privacy protectionsystems and spyware prevention products have only been in the market place fora limited period of time and may have longer sales cycles than our previousproducts.  Although response to ourproducts has been positive, we have not yet received broad marketacceptance.  We cannot assure you thatour present or future products will achieve market acceptance on a sustainedbasis.

 

In order to achieve marketacceptance and achieve future revenue growth, we must introduce complementaryproducts, incorporate new technologies into our existing product lines anddesign, develop and successfully commercialize higher performance products in atimely manner.  We cannot assure you thatwe will be able to offer new or complementary products that gain marketacceptance quickly enough to avoid decreased revenues during current or futureproduct introductions or transitions.

 

***We resemble a developmental stage company and our business strategy maynot be successful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions in a series ofsales from 2000 to 2002.

 

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As a result of these sales,we now depend exclusively on revenues generated from the sale of our networksecurity products, which have received limited market acceptance.  Moreover, we have only recently introduced ourregulated compliance and data privacy systems and our spyware preventionproducts.  Although initial response tothese products has been positive, the market for these products has only begunto emerge and sales of these products may not occur as quickly as we expect.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

 

•                  the need for our network security products,regulated information compliance systems, data privacy protection systems andspyware prevention products to achieve market acceptance and produce asustainable revenue stream;

 

•                  our ability to manage costs and expenses;

 

•                  our dependence on key personnel;

 

•                  our ability to obtain financing on acceptableterms; and

 

•                  our ability to offer greater value than ourcompetitors.

 

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products and regulated information compliance systems, our business,financial condition and operating results would be materially adverselyaffected.

 

***We incurred a net loss of $2.4 million for the nine months ended September 30,2005 and have an accumulated deficit of $51.2 million as of September 30,2005.  As a result, we must generatesubstantially greater revenues from sales in order to achieve profitability.***

 

We have incurred significantoperating losses and are uncertain about our future operating results.  For the nine months ended September 30,2005, we incurred a net loss of $2.4 million and had an accumulated deficit ofapproximately $51.2 million as of September 30, 2005.  We need to generate and sustain substantiallygreater revenues from the sales of our products if we are to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue indefinitely, and wemay never achieve or sustain profitability or generate positive cash flow.

 

***We face intense competition from both start-up and establishedcompanies that may have significant advantages over us and our products.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principle competitors inthe network intrusion and detection market include Internet Security Systems, Inc.,Cisco Systems, Inc., MicroSoft, Symantec, Inc., NetscreenTechnologies, Inc., McAfee, Inc., Tipping Point Technologies, adivision of 3COM Corporation, and NFR Security, Inc.  The market for regulated informationcompliance systems is relatively new. Our competitors in this market include a number of start-up companiesthat have entered the market in the last two years.  However, as this market develops, we expectincreased competition from both start-up and established companies.  Our current and potential competitors mayhave one or more of the following significant advantages over us:

 

•               greater financial, technical and marketingresources;

 

•                  better name recognition;

 

•                  more comprehensive security solutions;

 

•                  better or more extensive cooperativerelationships; and

 

•                  larger customer base.

 

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Although we believe ournetwork security products and regulated information compliance systems comparefavorably to our competitors’ products and create a sustainable business model,we cannot assure you that our products will achieve market acceptance or thatwe will be able to compete successfully with our existing or new competitors.

 

***Military actions may disrupt our business by reducing spending ourproducts, increasing our costs and affecting our international operations.***

 

We derive a substantialportion of our revenue from sales to United States government entities,including sales to various Army andother armed****servicesbases.  As a result, United Statesmilitary actions or other events occurring in response to or in connection withthem, including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

•              reducing or delaying government, armedservice or corporate spending on our products;

 

•              increasing the cost and difficulty inobtaining materials or shipping products; and

 

•               affecting our ability to conduct businessinternationally.

 

Should these events occur,our business, operating results and financial condition could be materially andadversely affected.

 

***Our products can have long sales and implementation cycles, which mayresult in us incurring substantial expenses before realizing any associatedrevenues.***

 

The sale and implementationof our products to large companies and government entities typically involves alengthy education process and a significant technical evaluation and commitmentof capital and other resources.  Thisprocess is also subject to the risk of delays associated with customers’internal budgeting and other procedures for approving capital expenditures,deploying new technologies within their networks and testing and accepting newtechnologies that affect key operations. As a result, sales and implementation cycles for our products can belengthy, and we may expend significant time and resources before we receive anyrevenues from a customer or potential customer. Our quarterly and annual operating results could be materially harmed iforders forecasted for a specific customer for a particular period are notrealized.

 

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

 

During the first nine monthsof 2005, we incurred $55 thousand in severance related costs.  Since we began restructuring in 2002, we haveincurred approximately $1.1 million in restructuring charges, severance, andrelated expenses. The objective of our restructuring plan was to reduce ourcost structure to a sustainable level that is consistent with our current cashresources and the general economic climate. We have also implemented other strategic initiatives to strengthen ouroperations, such as reductions in our work force and facilities and aligningour organization around our business objectives.  Any further work force reductions couldresult in temporary reduced productivity of our remaining employees.  Additionally, our customers and prospects maydelay or forgo purchasing our products due to a perceived uncertainty caused byour restructuring and other changes. Failure to achieve the desired results of our initiatives couldseriously harm our business, results of operations and financial condition.

 

***Consolidation in the network security data protection and spywareprevention industries may limit market acceptance of our products.***

 

Several of our competitorshave acquired security companies with complementary technologies in thepast.  We expect consolidation in thenetwork security, data protection and spyware prevention industries to continuein the future.  These acquisitions maypermit our competitors to accelerate the development and commercialization ofbroader product lines and more comprehensive solutions than we currentlyoffer.  Acquisitions of vendors or othercompanies with which we have a strategic relationship by our competitors maylimit our access to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market share, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

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***Sales to government entities accounted for 73.4% of our revenues thenine months ended September 30, 2005 and 53.6% of our revenues for the yearended December 31, 2004.  Sales togovernment customers involve unique risks, which could adversely impact ourrevenues.***

 

We derived 73.4% of ourrevenues from sales to various U.S. government entities for the nine monthsended September 30, 2005, and 53.6% of our revenues from these sales forthe year ended December 31, 2004. We expect to continue to derive a substantial portion of our revenuesfrom U.S. government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulationswith which we must comply and which can vary significantly amongdepartments.  As a result, cutbacks orre-allocations in the federal budget or losses of government sales due to otherfactors could have a material adverse effect on our revenues and operatingresults.

 

***We derived 10.6% of our revenues from international sales in the ninemonths ended September 30, 2005, and 19.2% of our revenues from thesesales for the year ended December 31, 2004.  Our ability to sell our productsinternationally is subject to certain risks which could harm our business.***

 

Sales to foreign customersaccounted for approximately 19.2% of our revenues for the year ended December 31,2004, and 10.6% of our revenues for the nine months ended September 30,2005.  We expect sales to foreign customersto continue to represent a significant portion of our revenues in thefuture.  Our international operations aresubject to many inherent risks that may adversely affect our business,financial condition and operating results, including:

 

•                  political, social and economic instability;

 

•                  trade restrictions;

 

•                  increases in duty rates and other potentiallyadverse tax consequences;

 

•                  exposure to different legal standards,particularly with respect to the protection of intellectual property;

 

•                  burdens of complying with a variety offoreign laws;

 

•                  unexpected changes in regulatoryrequirements;

 

•                  import and export license requirements andrestrictions of the United States and each other country where we operate;

 

•                  fluctuations in currency exchange rates; and

 

•                  changes in local purchasing practices,including seasonal fluctuations in demand.

 

***Sales through indirect channels accounted for 39.6% of our revenues forthe nine months ended September 30, 2005 and 36.9% of our revenue for theyear ended December 31, 2004.  Ourrevenues will suffer if we do not expand our sales through, or receive theanticipated benefits from our sales through, indirect sales channels.***

 

We derived 39.6% of ourrevenues for the nine months ended September 30, 2005, and 36.9% of ourrevenue for the year ended December 31, 2004, from sales through indirectsales channels, such as distributors, value added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  We believe we must expand oursales through these indirect channels in order to increase our revenues.  Although we are actively pursuing a strategyto increase the percentage of our revenues generated through these indirectsales channels, we cannot assure you that our products will gain marketacceptance in these indirect sales channels or that sales through theseindirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

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***We must adequately protect our intellectual property in order toprevent loss of valuable proprietary information.***

 

We rely on a combination ofpatent, copyright, trademark and trade secret laws, confidentiality proceduresand non-disclosure agreements to protect our proprietary technology.  However, unauthorized parties may attempt tocopy or reverse engineer aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent misappropriation of ourintellectual property.  This isparticularly true in foreign countries where the laws may not protectproprietary rights to the same extent as the laws of the United States and maynot provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incur substantial expenses defending ourselves against claims ofinfringement.***

 

There are numerous patentsheld by many companies relating to the design and manufacture of networksecurity systems.  Although we are notaware of any instances in which our products violate the intellectual propertyrights of others or inappropriately use their technology, it is possible thatthird parties in the future may claim that our products infringe on theirintellectual property rights.  Any claim,with or without merit, could consume our management’s time, result in costlylitigation, cause delays in sales or implementations of our products or requireus to enter into royalty or licensing agreements.  Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to our business.  Moreover, a successful claim of productinfringement against us or our failure or inability to license the infringed orsimilar technology on commercially reasonable terms could seriously harm ourbusiness.

 

***Fluctuations in our quarterly revenues may cause the price of ourcommon stock to decline.***

 

Our operating results havevaried significantly from quarter to quarter in the past, and we expect ouroperating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Although our revenues are subject tofluctuation, significant portions of our expenses are not variable in the shortterm, and we cannot reduce them quickly to respond to decreases inrevenues.  Therefore, if revenues arebelow our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly we may not attain positiveoperating margins in future quarters. Any of these factors could cause our operating results to be below theexpectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

 

***The price of our common stock has been volatile in the past and maycontinue to be volatile in the future due to factors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, forthe nine-month period ending September 30, 2005, the market price of ourcommon stock on The Nasdaq SmallCap Market fluctuated between $2.01 and $6.20per share.  The market price of ourcommon stock may fluctuate significantly in response to a number of factors,many of which are outside our control, including:

 

•                  variations in our quarterly operatingresults;

 

•                  changes in estimates of our financialperformance by securities analysts;

 

•                  changes in market valuations of ourcompetitors;

 

•                  announcements by us or our competitors of newproducts, significant contracts, acquisitions, strategic relationships, jointventures or capital commitments;

 

•                  product or design flaws, product recalls orsimilar occurrences;

 

•                  additions or departures of key personnel;

 

•                  sales of common stock in the future; and

 

•                  fluctuations in stock market prices andvolume, which can be particularly common among network security and other hightechnology companies.

 

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***Our reductions in our work force may make it more difficult for us toattract and retain the personnel necessary to successfully operate ourbusiness.***

 

We rely upon the continuedservice of a relatively small number of key technical, sales and seniormanagement personnel.  Our future successdepends on retaining our key employees and our continuing ability to attract,train and retain other highly qualified technical, sales and managerialpersonnel.  As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilate or retain other highlyqualified technical, sales and managerial personnel in the future, especiallygiven our recent reductions in force. The loss of any of our key technical, sales and senior managementpersonnel or our inability to attract, train and retain additional qualifiedpersonnel could seriously harm our business.

 

***Certain rights of the holders of our preferred stock may hinder ourability to raise additional financing.***

 

We cannot issueshares of capital stock with rights senior to those of our existing 5%preferred stock or Series 2 5% preferred stock without the approval of atleast a majority of the holders of our 5% preferred stock and all of theholders of our Series 2 5% preferred stock, voting or acting as separateclasses.  We also cannot incur certainindebtedness without the approval of at least a majority of the holders of our5% preferred stock.  In addition, holdersof the Series 2 5% preferred stock who are not executive officers ordirectors have the right to purchase a pro rata portion of certain futureissuances of securities by us.  Thecombination of these provisions could hinder or delay our ability to raiseadditional debt or equity financing.

 

***You will experience substantial dilution upon the conversion orredemption of the shares of preferred stock and exercise of warrants that weissued in recent private placements.***

 

On March 25,2004, we completed a $5,000,000 private placement in connection with which weissued 1,000,000 shares of our 5% preferred stock and warrants to acquire556,619 shares of our common stock.  Theconversion price for the preferred stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As of October 31,2005, there were 259,696 shares of 5% preferred stock, representing 413,003shares of common stock upon conversion, and warrants to purchase 556,619 sharesof common stock outstanding.

 

In addition, on March 28,2005, we completed a $2,663,000 private placement in connection with which weissued 1,065,200 shares of our Series 2 5% preferred stock and warrants toacquire 532,600 shares of our common stock. We also issued two affiliates of our placement agent warrants topurchase an aggregate of 60,390 shares of common stock.  The conversion price for the preferred stockis $2.50 per share and the exercise price of the warrants is $2.77 pershare.  As of October 31, 2005,there were 500,000 shares of Series 2 5% preferred stock, representing500,000 shares of common stock upon conversion, and warrants to purchase532,600 shares of common stock outstanding.

 

On October 31,2005, we had 6,909,507 shares of common stock outstanding.  As a result, we expect the private placementsto result in a further dilution to holders of our common stock upon conversionof the preferred stock and exercise of the warrants of 2,127,020 shares ofcommon stock, or an approximately 30.8% increase in the number of shares of ourcommon stock outstanding.

 

Further, theoccurrence of certain specified events controlled by the Company may entitleholders of our Series 2 5% preferred stock to require us to redeem theirshares for a number of shares of our common stock equal to the redemption pricedivided by 75% of the ten-day average of the volume weighted average price ofour common stock ending on the day immediately preceding the holder’s electionto redeem.  The redemption price for theshares of Series 2 5% preferred stock equals the sum of (1) thegreater of $3.25 and the volume weighted average price of our common stock onthe trading day immediately preceding the redemption event multiplied by $2.50divided by the conversion price of the Series 2 5% preferred stock then ineffect plus (2) any accrued but unpaid dividends on the Series 2 5%preferred stock plus (3) any unpaid liquidated damages or other amountspayable to the holders of the Series 2 5% preferred stock.  As a result, assuming we have paid allliquidated damages and other amounts to the holders, accrued but unpaiddividends on October 31, 2005 of $6 thousand, a volume weighted averageprice of $3.01, which was the ten-day volume weighted average closing price ofour common stock for the ten days ending October 31, 2005, and our6,909,507 shares of common stock outstanding on October 31, 2005, we wouldissue approximately 722,481 shares of our common stock if a specifiedredemption event occurs and all holders of Series 2 5% preferred stockelected to redeem their shares for common stock.  This would represent an increase ofapproximately 10.5% of the number of outstanding shares of our common stock asof October 31, 2005.

 

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***The conversion of preferred stock or exercise of warrants we issued inour recent private placement may cause the price of our common stock todecline.***

 

The holders of theshares of 5% preferred stock and warrants we issued on March 25, 2004 andthe holders of the shares of Series 2 5% preferred stock and warrants weissued on March 28, 2005, may freely convert their shares of preferredstock and exercise their warrants and sell the underlying shares of commonstock pursuant to effective registration statements we filed the SEC.  As of October 31, 2005, 740,304 sharesof preferred stock had converted into 1,177,327 shares of common stock, and565,200 shares of Series 2 5% preferred stock had converted into 565,200shares of common stock.

 

For the four weeksended on October 28, 2005, the average daily trading volume of our commonstock on The Nasdaq SmallCap Market was 10,975 shares.  Consequently, if holders of preferred stockor warrants elect to convert their remaining shares or exercise their warrantsand sell a material amount of their underlying shares of common stock on theopen market, the increase in selling activity could cause a decline in themarket price of our common stock. Furthermore, these sales, or the potential for these sales, couldencourage short sales, causing additional downward pressure on the market priceof our common stock.

 

***Our acquisition of complementary products or businesses may adverselyaffect our financial condition.***

 

We have made acquisitions inthe past, and, in the future, we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels.  Negotiation of potentialacquisitions and integration of acquired products, technologies or businessescould divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***The payment of accrued dividends on our preferred stock may strain ourcash resources, and our inability to pay these dividends could cause our stockprice to decline or could adversely affect our ability to raise additionalfinancing .***

 

Shares of our 5%preferred stock accrue cash dividends equal to $0.25 per share per annum,payable in arrears on March 31 and September 30 of each year, andshares of our Series 2 5% preferred stock accrue cash dividends equal to$0.125 per share per annum, payable in arrears on the first business day ofMarch, June, September and December of each year.  The amount of the dividends on our Series 25% preferred stock may increase to $0.45 per share per annum upon theoccurrence of certain event entitling the holders of these shares toredemption.

 

During 2004 wepaid $129 thousand in dividends related to our 5% preferred stock.  During 2005, we paid $90 thousand and $47thousand in dividends related to our 5% and Series 2 5% preferred stock,respectively and at September 30, 2005, we have dividends accrued of $49thousand related to our 5% preferred stock and $6 thousand related to our Series 25% preferred stock.

 

Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years ended December 31,2004.  However, we did have sufficientcapital surplus, defined as the amount by which our net assets exceed ourstated capital, based on par value of our outstanding shares as provided byDelaware law.  Although we are currentlyable to pay accrued dividends on our outstanding shares of preferred stock, wecannot assure you that our net assets will continue to exceed our statedcapital or that we will have net profits in order to pay these dividends in thefuture.  These dividends continue toaccrue on our outstanding shares of preferred stock, regardless of whether we arelegally able to pay them.  The accrual ofthese dividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business.

 

In addition, ourinability to pay dividends could require us to redeem outstanding shares of Series 25% preferred stock in exchange for shares of our common stock issued at a priceequal to 75% of the average of volume weighted average price of our commonstock for the ten days ending on the day immediately preceding an election toredeem.  As a result, the issuance, orpotential issuance, of these additional shares of our common stock could causeour stock price to decline.  Furthermore,our inability to pay these dividends in cash could adversely affect our abilityto raise equity financing in the future if required.

 

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***Compliance with export regulations may hinder our sales to foreigncustomers.***

 

Certain of our data securityproducts incorporate encryption and other technology that may require clearanceand export licenses from the U.S. Department of Commerce under United Statesexport regulations.  Any inability toobtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

***Provisions of our charter documents and Delaware law may haveanti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions of Section 203of the Delaware General Corporation Law, which restricts certain businesscombinations with interested stockholders and could inhibit a non-negotiatedmerger or other business combination.

 

***Our management and preferred stockholders exercise significant controlover our company and may approve or take actions that may be adverse to yourinterests.***

 

As of October 31, 2005,our executive officers, directors and preferred stockholders beneficially ownapproximately 23.7% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and the approval of significant corporate transactions, whichcould delay or prevent someone from acquiring or merging with us or providingus with additional financing if required. These stockholders may use their influence to approve or take actionsthat may be adverse to your interests.

 

Item 3.                                CONTROLS AND PROCEDURES

 

We have carried out anevaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of September 30,2005, pursuant to Rule 13a-15(b) under the Exchange Act.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed is recorded, processed, summarized and reported in a timelymanner.

 

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended September 30, 2005, and our Chief ExecutiveOfficer and Chief Financial Officer have concluded that there was no changeduring the quarterly period ended September 30, 2005 that has materiallyaffected or is reasonably expected to materially affect our internal controlover financial reporting.

 

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**PART II– OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

Item6.                                EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                      The following Exhibits are filed with thisreport form 10-QSB:

 
| 31.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
| 32.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(b) of the Exchange Act  and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(b) of the Exchange Act  and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |

 

(b)                                     During the quarter ended September 30,2005, we did not file any reports on Form 8-K.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
| ** **                    | **INTRUSION INC.**                                                        |
|-------------------------------|---------------------------------------------------------------------------|
|                          |                                                                      |
|                          |                                                                      |
| Date: November 10,  2005 | /s/  Michael L. Paxton                                                    |   |
|                          | Michael  L. Paxton                                                        |
|                          | Vice President, Chief  Financial Officer,  Treasurer & Secretary |
|                          | (Principal  Financial & Accounting Officer)                      |

 

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